Tax Incentives for Startups - Part 1: Overview

Tax Incentives for Startups - Part 1: Overview

Today is the start of the new financial year, and investing in Australian startups is now more tax efficient. The latest limb of the Government’s National Innovation and Science Agenda (NISA) is now in effect. This new tax scheme – the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 – is designed to drive a more innovative, entrepreneurial culture in Australia.

Over a series of blog posts we’ll run through the tax changes and how they affect you. In this first post, we’ll give an overview of the headline changes to existing legislation. We’ll follow this post with two more in the series on the impacts and details of the changes as they affect the key stakeholders. Our second post will focus on startups and our third post will focus on investors.

For this overview, we’ll keep to the key points. In the following posts we’ll expand on these key points in simple terms and include some case studies to illustrate how the new changes work.

For Startups

Startup founders in Australia face a funding gap between pre-concept financing (through self-funding, family, friends and Government grants) and financing through venture capital at a later stage of their development. The objective of the new tax changes is to incentivise private investors to bridge this funding gap through beneficial tax treatment for equity investments. For founders, it’s crucial that new investors can access these tax incentives, and the key to this is ensuring the startup is classified as an Early Stage Innovation Company (ESIC).

What Is An ESIC?

To be an ESIC under the new rules, companies must be classed as both ‘Early Stage’ and ‘Innovative’. It’s much easier to identify whether or not a company as early in its development than it is to determine whether a company is developing innovative products, services or processes. To reflect this distinction, the ‘Early Stage’ test regime is objective whereas the ‘Innovation’ test regime is more flexible, with dual objective and subjective pathways.

Early Stage companies are classified through an objective, four-part testing regime:

1.    Incorporation or Registration of the business in the last three years

2.    Total Expenses reported by the company must be < $1.0m for the previous income years

3.    Total Income reported by the company must be < $200k for the previous income year

4.    Not listed on any stock exchange in Australia or overseas

Innovation is measured through a dual process whereby startups must satisfy either a principle-based (subjective) regime or an activity-based (objective) regime:

1.    Subjective Regime – the following principles must be demonstrated:

•      New or significantly improved good, service or process  

•      Commercialisation 

•      High growth potential

•      Scalability

•      Broader than local market capability

•      Competitive advantages

2.    Objective Regime - the following activities count toward a 100-point goal:

•      Significant R&D claims (up to 75 points)

•      Receiving an Accelerating Commercialisation Grant (75 points)

•      Completing an eligible accelerator program (50 points)

•      Third party investment of more than K (50 points)

•      Enforceable IP (up to 50 points)

•      Research or university commercialisation collaboration (25 points)

It’s worth noting that startups need only satisfy one of the above innovation test regimes. If an early stage company can’t meet the Subjective Regime, they are still able to be classified as 'Innovative' by tallying 100 points in the Objective Regime. If you're interested in more detail on how the changes affect startups, check out our second post in this blog series.

For Investors

The legislation changes introduced for investments in ESICs are available to all types of investors, regardless of their preferred investment method. The two key incentives are a tax offset of 20% and a capital gains tax (CGT) exemption for investments of between 1 and 10 years. We’ll step through the key headline terms you need to know about each incentive.

Who Is Eligible?

All investors are able to access these tax incentives, but there are some restrictions to encourage the right behaviour from investors qualified to receive the benefits:

•      Investor Entity - investors are able to invest through their preferred investor entity

•      Individual Investors - non-sophisticated investors get a benefit of up to $50,000 p.a. 

•      Residency - an investor entity’s residency won’t affect the tax benefit

What Are The Limitations?

The tax offset is designed to encourage new investment in ESICs rather than merely subsidise existing investment. Eligibility for the tax offset is based on income year when the shares were issued and is based on the following criteria:

•      Newly issued

•      Equity only

•      Convertible securities

•      Not a part of an Employee Share Scheme

•      No related relationships

•      Less than 30 percent equity interest

Investments satisfying the above are likely to be able to be offset by eligible investors.

What’s Changed?

Under the old regime investors in early stage innovative companies received no direct benefit via an offset and would only receive a CGT discount if shares were held for greater than one year. However, the recent changes provide qualifying investors funding such companies with a tax offset and a capital gains tax (CGT) exemption for their investments. The tax offset has the following characteristics:

•      20% offset amount

•      Investment limit of $1.0m

•      No affiliates

•      Non-refundable

•      Able to carry forward

The CGT exemption has the following characteristics:

•      Shares held for less than 12 months are not included in the regime

•      Shares held for 1-10 years get the CGT exemption

•      Shares held for more than 10 years receive the exemption for only the first 10 years

That’s all for the first post in our series on the new tax legislation for startup investment. If you’re interested to learn more, stay tuned for the second post in the series covering the details as they apply to startups. Our third and final blog post in the series will focus on the implications and details of the new legislation as they apply to investors.

The above is based upon the views of Equitise and does not represent formal tax advice.

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